Wednesday, December 31, 2008

How Succesful Is Fiscal Policy In Preventing A Recession In UK? (forecast essay)

Fiscal policy: Defined as the manipulation of government spending & level of taxation to influence the movement of AD

"Preventing a recession" indicates that UK economy could be slowing down significantly. To prevent a recession, it is necessarily for the UK government to pursue expansionary/ reflationary policy by slashing tax & increasing public spending

How does this works?

(1) Slashing direct & indirect tax. Direct tax refers to income tax & corporation tax. By paying lower income tax, individuals will have greater amount of disposable income. As such this may increase overall spending into the economy. Lower corporation tax may put companies in higher retained profits position. As such this increases their incentive to invest such as acquire modern capital goods, build factories etc. This will increase I which is one of the component of AD. Lastly, UK government can reduce VAT on goods produced. Like now, the slash in 2.5% of VAT will make goods cheaper, thereby encouraging more purchases. All these shift AD curve right & thereby reducing the possibility for recession to take place

(2) Increase public spending. When government allocate more funding for public services, such as onto schools, hospitals, infrastructures, public transport, telecommunications etc, it has a direct effect onto AD. Also this may positively affect other components of AD. Firms will gain a windfall profit when they are engaged with government’s project. More money can be reinvested into operation later. Along the way, it will create more employment thereby increasing spending into UK economy. All these shifts AD rightward, thereby preventing the possibility of recession


(1) Lags. Fiscal policy suffers from all lags. Government tends to be too ‘careful’ in announcing a shock e.g. recession has happened in the economy. The sub prime mortgage time bomb has actually happened end of last year & only now they are aggressively countering it (recognition lags). When it comes to implementation, it may take months to years. The proposal will have to go through various legal procedures, departments & including securing a planning permission (implementation lags). Once executed, it further takes some time for the effect to be seen in economy (effect lags), e.g. increase in real GDP, fall in unemployment etc. Monetary policy is seen to be more efficient as it’s free from implementation lags

(2) Crowding out effect. Increased government spending may likely lead to deficit. As such government may need to get financing by issuing bonds. Private sectors will take up those bonds & as such have lesser allocation for investment. As such we say private sectors are crowded out. Another way to look at this will be, government increase borrowing from commercial banks. With greater competing demand for money, interest rates will be bid up. As such this will reduce spending & investment, leading to lower growth in long term

(3) Tax reduction may not work. Reduction in income tax may not necessarily induce spending into the economy if the reduction is insignificant. Furthermore it depends on which category of income bracket is affected e.g. lower-middle income or high income? If it affects those on higher income, spending will not increase much given the nature of their low mpc (marginal propensity to consume—tendency to spend). However one could argue that lower tax rate may reduce cases of tax evasion

(4) Limit on government spending. UK’s national debt is ballooning from its low in 2001 (29% of GDP) to its current high of about 44% of GDP. Economists predict that these figures are actually much larger than what it seems since its calculation exclude pension liabilities in future. This is worrying given the increasing size of ageing populations. Growing public debt also pose other problem such as higher taxes onto future generations to pay back all the moneys borrowed. However some argued that this is not much of problem since UK managed to recover from greater national debt of 70% of GDP in 1970s

(5) Consumer confidence. Perhaps, consumer confidence & house prices are 2 of the most important macroeconomic indicators. If consumer’s outlook is bleak & house prices continue to fall no matter what policies pursued by the government it wouldn’t work to steer the British economy forward. Consider Japan. The government has pursued deficit spending amounting to 194% of its GDP, slash in income tax & even interest rates maintained at 0%, yet it fails to revive economic activity

Tuesday, December 30, 2008

Happy New Year Wishings!

I would like to take the opportunity to greet all fellow readers & my students, Happy New Year! May the year of 2009 will be another great jump-start to all efforts that you have put in earlier. To my students, may you are blessed with great grades & get a good place in top universities. I know some of you are looking for MIT, Stanford, Cambridge, Oxford & LSE

Also to other readers/ business people, try to look at the economic downturn POSITIVELY. There could be blessings in disguise. This could be a good opportunity to seize your weakening business rivals, enlarge your market share & hire brains at your company at discounted wage. There are so many proffesionals coming back from overseas & desperately looking for job now. Who knows, maybe you could exert your 'monopsony' power

And to all my friends, sorry for not spending much time with you all. 2008 is the busiest year in my life that I wish I have 30 hours a day!

To my colleagues, well I'm truly optimistic we are in the A-Team & A Level higher than the rest. Thanks to my boss, Mr. Jahn for allowing me to be part of the maestro. To Datuk Dr. Paul, I always 'admire' (if not people will think otherwise) you from the back. Your business frontier is undeniable. Truly a great tycoon. I now began to look at things from businessman point of view! Everything! Cost saving, efficiency etc

To all other HELP colleagues, we need to push harder for sales! Our rival, is 'sewing us' if you know which college I meant. Anyway since they play dirty, we must play the dirty game too!!

Video Lesson by Phil Holden: Keynesian vs. Monetarist View of LRAS

Why Wage Differentials Exist In Labour Market?

In Labour Economics, it is often assumed that the labour market is perfectly competitive:

(a) There are many hirers or employers (buyers) & many potential workers (sellers). Each of them is small enough & thereby unable to exert any power onto the market. As such each market participant is a wage-taker

(b) All labours are homogenous

(c) Both employers & employees have perfect knowledge of market conditions

(d) There is no government intervention

However these conditions are just a proxy & a satisfactory model to the real situation. In reality, we know that labours are not homogenous. A farmer will not be able to become a doctor or a pilot. The same goes for wage-taking. In real life, some employers have monopsony power & as such they can command the wages that they are paying. Also we have strong labour unions that can restrict the supply of labour into certain market. Government also can intervene in the labour market e.g. imposition of National Minimum Wage (NMW)

Why wages differ so much between individuals?

(1) Age. Older workers are paid much higher salary since they are likely to have much experience over the young ones. Experience is important since it could lead to better knowledge of working conditions, effective decision making etc

(2) Sex. Women are traditionally paid lower than men due to many factors. For instance, women are highly concentrated in sales-related jobs e.g. shop assistant, in-out of job too often due to maternity, lesser education etc whereas men are more into professional areas e.g. specialist doctors, taking stressful jobs e.g. investment banker etc . Although the trend is less apparent in the present, still the concept of glass-ceiling appears everywhere. Women are denied the role of leadership in many positions. We will talk this in greater detail next posting

(3) Ethnic. Racial discrimination still appears in workplaces although governed by 1976, Race Relations Act & Commission for Racial Equality. The minority ethnics are very often denied the chance of climbing up corporate ladder. However one could also argue that other ethnics may treat English as their secondary language especially immigrants. Also they receive lesser formal education compared to the Whites

(4) Personality. Different people have different mentality, attitude & aptitude towards work. Some are hardworking while some others are lazy. Normally those who are highly capable will command great attention & care from their bosses. No doubt, one could also argue that political skills in office could be a much greater influence in determining one’s position

(5) Different MRP (marginal revenue product of labour). MRP means an additional revenue gained by selling extra 1 more unit of output. It is also the demand curve for labour. MRP is closely associated with MPP (marginal physical product) & MR (marginal revenue). It is given by MPP = MRP x MR

MPP means additional output by hiring extra one worker) & MR means additional revenue due to extra one unit of output sold. As such workers with higher productivity tend to get higher salaries. The same goes for those who produce profitable goods. For instance heart specialist or professional footballers like Beckham are highly paid due to their high MR

(6) Nature of jobs. Wages are only signal for allocation of labours. In reality when one choose a job, they will look at many other factors for instance level of stress, perks such as company cars, danger involved, health benefits etc. Other things being equal, jobs with unpleasant environment will have to pay higher to attract workers. For instance, working as an investment analyst in Swiss Bank will likely pay higher than a teacher given the challenging nature of finance e.g. high stress

(7) Backed by strong unions. Trade or labour unions are organisations where workers group together to further their interest. They often have strong influence over they pay of their members since they bargain collectively rather than individually. More often than not, this will result in exorbitant rise in production costs for employers. UAW (United Auto Workers) for the Big 3 is a good example. What they normally do is restrict the supply of workers in certain industries to drive wages up. Also union workers often have higher pay than non-union workers

(8) Powerful corporations. Meanwhile, there are also some firms which are very influential. They hold the monopsony power as the single buyer of labours. These types of firms are able to set their own wage rather than employing at the going-wage rate as in perfectly competitive labour market. They may have the power to drive down wages. Those employed in such industries may have a lower pay scale on the average

How Effective Is Monetary Policy In Countering Deflation In UK?

In Japan, price level is falling severely from the period of 1998. Inflation is negative for such a long period. The Bank of Japan begins to increase interest rate only in late 2006

Expansionary/ reflationary/loose monetary policy are pursued to prevent the price level from falling down

Monetary policy attempts to influence the movement of AD by manipulating the level of interest rates

Here, the deflation that occurs is likely due to weakening of spending into the real economy. As such, attempts must be made to move AD to the right via interest rates cut

How does monetary policy work to counter deflation?

(1) Consumption.
In theory, cut in interest rates actually create a disincentive for people to save. Also with lower interest rates, more people will find that purchasing items by credit is now cheaper. As such it will fuel spending onto property, cars, plasma TV etc. Meanwhile for people with existing debt, they will find that mortgage interest repayments as a % of their income has shrunk. This means increase in disposable income & more can be spent onto other goods. All these 3 will lead to increase in consumption. AD will shift right, thus preventing the price level from further falling down

(2) Investment. Lower interest rates also encourage more entrepreneurship activities. More firms will be taking up credit financing to enlarge existing operations, to acquire other businesses, buy capital goods, build new factories etc. Their interest to do so increased, as lower interest rates translate to higher return on capital. As I is a component of AD, this will jump-start AD & thereby prevent price level from falling

(3) Export. Lower interest rates will cause pound to depreciate. High net worth individuals, hedge funds, pension funds etc will probably withdraw savings from UK to seek for higher return elsewhere, causing heavy selling of pound. Somehow, cheap pounds will help to boost demand for UK exported goods. As X increase (assuming M constant), this should help to push net export higher, thereby an increase in AD


(1) No implementation lags. MPC had gained independent since May 1997 from Labour government & as such its operation is said to be free from political influence. Also they conduct meetings every first week of the month & interest rate decision is made a day after that. As such it is fast & efficient

(2) Effect lags. Monetary policy may suffer from effect lags. It is said that any effect onto the real economy can only be seen in 18 months time. In other word, the recent interest rate cut may not produce any result at least until June 2010. This is because many people are switching to fixed rate mortgages, especially in the period of early 2000s where interest rates are steadily rising. Therefore their consumption pattern may not change immediately

(3) Consumer confidence more important. Interest rate cut may not produce desirable result, if consumer confidence is falling drastically owing to the property market slump. Japan is a good example. In the period of economic depression, all have been done including driving interest rates to 0%, cutting income tax & explosive government spending up to 194% of their GDP. But none of them work. As cut in interest rates fail to stimulate spending, we call this phenomenon as liquidity trap

(4) Undermining effectiveness of traditional tool. There is a limit into the working of traditional monetary tool. For instance interest rates can’t fall below 0%. In UK, key rates standing at 2% means there is still room for MPC to manipulate the rates. Unfortunately, in US the official rates are now at between 0%-0.25%, which doesn’t make much difference by saying that it stands at 0%. Therefore, we say in US monetary policy has completely lost its effectiveness since rates are so low & it fails to kick-jump the economy

(5) Quantitative easing. There are still other monetary tools that can be pursued by MPC if the rate cut is ineffective. It’s called quantitative easing. This refers to large scale of buy-backs of government debt by BOE. The purpose is actually to increase liquidity in financial system, hoping that banks will eventually resume their operation as usual. This was an option considered by the Japanese government during the period of depression in late 1990s. Although this is said to be possibly contributing to high inflation or hyperinflation, the possibility is remote

(6) Positioning of UK economy. In the current period, very likely there is high spare capacity in the economy. As such any cut in interest rates, in theory, will be able to give a large boost to real GDP without causing much inflationary fear in the future

(7) Banks not co-operating. In the current period, banks are seizing opportunity to rebuild their balance sheet e.g. recoup some of the earlier losses. As such, they are reluctant to pass on the full interest rate cut. For e.g. fall in 1%, only 0.25% will be given to borrowers. As such costs of borrowing remain high & therefore this defeat the objectives of monetary policy. Also costs of interbank lending (LIBOR) remain high & this further tightens the credit crunch

(8) Deflation not necessarily bad. If the falling price level is due to increase in competition, higher level of investment in technology, greater productivity etc then the outcome may not be bad. This is because, as AS curve shifts rightward price level will fall & yet there is an increase in real GDP. Also consumers’ welfare may increase as they are now paying lower price & yet enjoy more goods
(9) Couldn't be targeted to certain sectors. Monetary policy could be argued as a blunt policy tool. Once the decision is being made, it actually affects all sectors of the economy. On the other hand, fiscal policy changes can be targeted to affect certain groups such as means-tested benefits for low income households, reductions in corporation tax only for small-medium size enterprises, investment allowances for businesses to set up in certain region etc

Monday, December 29, 2008

Is Deflation Good Or Bad?

Economics always create wonders out of nowhere! It was not long ago, when everyone on the street was talking about the danger of inflation, particularly oil price peaked to $147 per barrel on July 11th. Somehow, just months after that economic scene have totally changed. Inflationary pressure is no longer on the radar when oil price fell below $40. Now, it’s the D-factor & I’m referring to deflation

What is inflation-deflation?

Inflation is the sustained increase in general price level. Meanwhile, deflation means a fall in general price level. It’s just the other way round. Price level is falling fast in UK now, led by slump in housing market. Economists predicted that the real impact of deflation will be fully felt next year

You may argue, isn’t a good thing when everyone can buy things cheaply? Well, my answer is YES & NO. Yes, if it lasted for months. No, if it lasted for years like in Japan. In short, inflation & deflation are both equally dangerous to economic health

Before we proceed, I would like to show an important calculation here. Say, nominal interest rates 0% (like in US now) & inflation is 5%, so real interest rates = 0% - 5% = -5%. Therefore it serves no point saving your money in bank account. But in period of deflation, say inflation is -5%, therefore real interest rates = 0% - (-5%) = 5% had increased

Why deflation is bad?

(1) Defer in spending. Deflation creates a disincentive for people to spend now. This is because people expect the price to further fall in the near future. Why buy a house now, when probably one can buy it at 10% cheaper next 3 months? When everyone thinks the same, the economy will contract faster, driving the price level lower. Then, again people will wait rather than spend, since they saw further space for the price to rock bottom. This is particularly true in UK & US since the economic growth is consumption-led. In this period, savings will also increase. This is consistent with scenario in Japan. The ‘long-lost decade’ experienced in 1990s to 2000s shows how danger deflation is. This is also the period where the Japanese stack up their savings to the extent of the US’ GDP

(2) Borrowing is expensive. As shown in the calculation above, deflation causes a rise in real interest rate when the nominal interest rate remain constant (0%). As such, it means costs of borrowing have increased. Households will reduce their consumption on huge items on credit such as plasma TV, cars, houses etc. Meanwhile, firms will cut their spending significantly on acquisition of capital goods, building of new factories etc. It makes economic sense for firms to do so. First, there is great uncertainty as to when they can breakeven. Second, there could be a shift in customers’ mindset, therefore changing the consumption pattern

(3) Increasing debt.
In the period of rising inflation which is normally followed by rise in wages, the real value of mortgage will be progressively reduced. A monthly mortgage payment of $ 600 will become attractive since it becomes smaller as a % of our income. However, with deflation & period of falling income, the value $ 600 as % of our income grew larger. This means increasing burden, fall in disposable income which lead to fall in consumption & contraction in GDP. The same applies for firms

(4) Higher wages cost for firms. Depending on how this is argued. In current period, workers especially those backed by unions will seek to prevent a cut in the nominal wages. It has 2 impacts which are equally bad. First, firms that are unable to maintain at such wages will resort to sack workers, thus creating real wage unemployment. Second, firms may not be able to sack many of those workers to reduce operating costs significantly if they are backed by strong unions. As such, their profit margins will become thinner or even make losses. GM, Chrysler & Ford typically face such problem. Their workers are backed by strong union called UAW (United Auto Workers)

(5) Falling share prices. In period of deflation, where real economy contracts at such speed it is norm to see company making smaller profits or even make losses. At such they may need to cut dividends payout to shareholders. This caused a bad valuation upon the firm. More people will be dumping its shares. Heavy selling will drag the price lower. This explains why Dow Jones & FTSE fell in the recent months, although there could be other factors. This may pose a greater threat to US economy than UK, since only a fraction of Britons actually store their wealth in shares

(6) Undermine the ability of monetary policy. Monetary policy has always been an ‘effective’ tool to boost spending into the economy & to control price level. Since the outbreak of contagious deflation, its effectiveness has come to an end. Despite the aggressive stance taken by the Fed to cut rates from 5.25% (September 2007) to now 0%, it doesn’t seem to work at all. The same goes for MPC. Interest rates had went down from the peak of 5.75% (September 2007) to 2% in December 08, but fail to prevent the housing market slump in UK. For States, we said that the monetary policy has run out of ammo!

Good thing about deflation

(1) Narrowing income inequality. Income gap has always been large in both UK & US. In the period of economic contraction, usually those executives with fat pay checks will be the first to go, as firms are reducing costs. But no doubt this argument also depends on which industry we are referring to. This could be more applicable to financial sectors in both UK & US. Wall Street wizards are now poorer. Share brokers really go broke due to thin transactions in financial market

(2) Bargain hunting. It often happens at the turn of all business cycle. For those who accurately time the market, will enter & buy good shares at ‘discount’ prices. The same goes for property market. If plans work out, normally those middle income people will turn themselves into high-income bracket once the market fully recovers. High share & property prices mean greater wealth, which will steer the economy. The only problem is, no one can actually time the market, not even Wall Street gurus

(3) Build up savings. From the calculation above, it is obvious that deflation can actually increase the real value of savings. It would be appropriate for Americans & Britons to consider building up their financial position once again. From the PPF argument, increase in savings can be channeled for investment which will shift the curve outward in future. Also, banks will have more cash to lend out & they will reduce their exposure to money markets just like before

(4) Good opportunity to expand through mergers. In the current period of credit crunch, many smaller firms but with great growth potential have problems in their balance sheet. Larger firms which are cash-rich may take this opportunity to acquire good firms sold at attractive prices. Furthermore, there are likely be lesser competitors bidding for it

Public Goods & the Failure of Free Market

Public fireworks, sample of public goods . We are not talking about fireworks in closed parks

Streetlights, another example of public goods. The man on the left does not reduce the lights available to the next person. Neither does he can exclude that person

Over the years, the British government has embarked an ambitious spending on public goods which amount up to billions. To really appreciate the topic of discussion, it would be appropriate if we understand how is a good being classified as public good?

Public goods must have 2 characteristics:

(1) Non-rivalry: The consumption of the good by one individual, will not reduce the amount available for someone else to consume

(2) Non-excludability: Once the good is provided, no one can be excluded from benefiting it

Examples of public goods: fireworks, BBC television program, national defence, street lightings

I would pick fireworks since we are moving to New Year. Fireworks are considered as public good since it fulfil both the characteristics. First, it is non-rivalry. If I stare into the sky & I saw 20 blasts, I don’t reduce the amount of blasts watch by another person, say to 10 blasts

Second, non-excludability. If I get to watch & enjoy the scene of fireworks, I can’t stop someone else standing next to me from watching it

Let’s consider street lights. If I was standing under the street light momentarily, before moving on, I do not reduce the amount light available for other passers-by. Second, I can’t prevent someone else from standing below that streetlight

Market failure

Why public good is considered as a form of market failure? Simple, because the private sectors will not have the incentive to provide it since there is no certainty over the economic profit. This is due to the characteristics of public goods mentioned above. Once provided, the private firm will not be able to prevent someone who is not paying for it from using it. In other word, free-rider problem

Saturday, December 27, 2008

Theo Fennell & Income Elasticity of Demand

In the recent (23rd December), Theo Fennell, the British prime jeweller had reported its first ever loss in 3 years amounting up to £ 840,000. Its sales dropped by 20% for the period of six months to 30th September

Why is it so?

Before going into that question, I would like to introduce the economic tool of analysis called income elasticity of demand (YED)

Definition: YED measures the responsiveness of quantity demanded due to the change in income

The formula is given by, YED = (% change in quantity demanded) / (% change in income)

Application of YED

While PED (price elasticity of demand) is used to determine how sensitive certain goods towards price changes, XED (cross elasticity of demand) to determine relationships of 2 goods (whether it’s substitute or complements), YED is meant to identify the types of goods or services

(1) YED less than 0

We normally refer them to crush grain, Tesco brand bread, instant noodle etc. Here inferior goods are something that we consume lesser when our income increases. This explains why the outcome of calculation can be negative since (-% demand) / (+% income). Of course, it works vice versa. In period of difficulty or running a tight budget, our consumption on these inferior goods will increase. So (+% demand) / (-% income)

(2) YED, more than 0 less than 1

Necessities are normally clothes, toothbrush, newspaper etc. Here demand will rise along with income but less than proportionate. Therefore it yields a positive figure which is less than 1. For instance, (demand + by 30%) / (income + by 60%) = 0.5. Of course it works the other way round

(3) YED greater than 1 (luxury goods)

We often refer luxuries to things like international holidays, jewelleries, designer clothes etc. In the period of economic slowdown like now, normally businesses selling these items will be the first hit. Households would be more concern with their savings & family balance sheet. Here demand will fall along with income but greater than proportionate. Say, (demand -60%) / (income -50%) = 1.2 (positive figure). Of course it works the other way round

Back to our analysis, here Theo Fennell is in jewellery business. As such what they sell is classified as luxury goods. No wonder, their sales dropped significantly

Friday, December 26, 2008

Bernard Madoff-Ponzi Scheme

Charles Ponzi, in tribute of him

Mr. Madoff in his office, Bernard. L Madoff Investment Securities, LLC

After a series of economic & financial shock from US, we were lambasted with another big news that swept across newspaper’s headline in the West. It is non-other than Bernard Madoff. This name could be alien to my fellow Economics students, but he is a well respected figure. His legacy of helping investors to consistently earn 11%-13% on top of their investment is no secret, even in times of turmoil. He is even been made the Chairman of Nasdaq

This man had a very humble beginning as a lifeguard & installing sprinklers. He started his company in 1960 with an initial $5,000 & then called it Bernard L. Madoff Investment Securities LLC. His reputation is so strong, that he had an ego of turning down some of the richest man that courted him for access to his miracle investment scheme

There are few things that amazed me:

(a) How does an ordinary lifeguard & sprinkler installer know so much about the working of the financial market, regulatory framework & its loopholes?

(b) How come his sons are not aware of their dad’s activities?

(c) US has the best & yet the most sophisticated financial market regulator called the SEC (Securities & Exchange Commission). How come it fails to detect the financial fraud much earlier & letting it operate for nearly 4 decades?

(d) Why are those big banks with world most talented brains & management such as Swiss Bank can be swayed into trusting the Ponzi scheme (in recognition of Charles Ponzi) & earning superior returns even in period of difficulty?

How does Ponzi scheme work?

It’s rather easy. There is no hassle to earn CFA (Chartered Financial Analyst) title or PhD in Finance, or becomes a well-known Wall Street figure. The organiser didn’t actually invest any of the money handed to him. What he did was, to use new depositors’ money to pay off the earlier depositors

Let’s consider a simple scenario of 26 investors, labeled A-Z. At first there will be 3 investors, called Mr. A, B & C. Then the organiser will fool Mr. D (which is very rich) in joining the scheme. Eventually, the money handed in by Mr. D will be used to pay off earlier investors (A, B & C) without actually investing it. Say in the end when Mr. X, Y & Z joined the scheme, the money they threw in will be used to pay the so called ‘profit’ made by investors A-W

However you may argue, in order for the scheme to work does it mean that Madoff has to continuously look for richer investors so that earlier investors can be paid off? My answer is not necessarily. If he successfully found one, it will be good as it means more cash in circulations. If not, it’s not a problem anyway. Why? Those investors at the earlier chain are probably driven by greater greed now. Greed dominates their rationale. In reality, most of them reinvest the paycheck they got hopefully they can earn more superior returns

Say, initially Mr. A threw in $ 5, 000. As promised earlier, a 20% return would give him $6,000 next year. Driven by greed & confidence with the organiser, he will choose to reinvest that $6,000 rather than cashing. He hopes that by another year, the amount will further grow to $7,200. This carries on

In what circumstance the scheme will come to an end?

(1) Time to get out. Once the organiser feels that he had made a considerably fortune for himself, he will leave the game & disappeared with all those monies

(2) Outnumbered. If participants are increasing abnormally, the organiser could find great difficulty in paying off the existing ones. More time will be spent onto managing existing accounts, leaving him lesser time to lure new ‘victims’. At the end of the day, there will be lesser monies coming in & he may liquidity problem. Words of fraud may begin to spread. It works incredibly like multiplier effect. Later more investors will want to withdraw, causing tighter liquidity for him

(3) Regulators. If the scheme is so successful, he may attract regulators to probe him. Regulators will ask for accounts of transaction, something that he may not be able to provide. Surprisingly, Madoff escape this. Miracle isn’t it, after SEC letting this slip of from their hand?

(4) Credit crunch. The main reason why Mr. Madoff fails in the end is due to credit crunch itself. Due to period of difficulty more investors want their money back. After all, having cash in hand now is perceived the safest. Secondly, he fails to attract more people to join the scheme in current period. Third, even those big guns who want a shot, may find difficulty to get credit from banks. All these lead to shortage of cash & yet people who demanded their money back is on increasing scale. The scheme's life cycle has come to an end!

Among well-known victims of Madoff:
(a) Steven Spielberg
(b) Frank Lautenberg, US Senator
(c) RBS (Royal Bank of Scotland)
(d) Swiss Bank
(e) BNP Paribas
(f) Aozora Bank (Japan)
(g) Abu Dhabi Investment Authority

In Malaysian, we have similar scheme which was given the name ‘Pak Man Telo’. The one who organised it was called Osman Hamzah, a part time reporter in Perak. He started the scheme in 1972 & cheated nearly 50,000 investors with value of money at RM 99 million in hand that time.
Perhaps, he could have made much fortune just like Madoff if he operates in US or maybe even longer due to loopholes that exist.

Types of Unemployment & Solutions

People registering themselves at JobCentres
Unemployment: People who are in the working age (16-65) & economically active, but couldn’t find a job despite active search for it

That is a very general term to refer to people who are unemployed

However, unemployment may not be as simple as it seems. In fact we do have a branch of economics called Labour Economics (Unit 5A) but unfortunately Edexcel scrapping it soon. Final exam will be in June 2009

Types of unemployment & solutions

(1) Frictional unemployment. Time taken for individuals to move in between jobs. Suppose Mr. A has been out of job for several months & as such he is looking for a new one. In between, he registered himself as unemployed & entitled himself to claim jobseeker’s allowance. Sometimes, ‘the dole’ could act as a strong disincentive for someone to look for job if the claim is high. Also sometimes they took longer than necessarily to look for jobs, is due to imperfect information, not knowing which local firms that offer vacancies. Both these actually worsen the frictional unemployment

Solution: Like UK, they have set up JobCentres, a government-funded agency (something like Jobstreet in Malaysia) that helps people to look for suitable employment & firms to fill in vacancies. Also the government can cut unemployment benefits, to increase the opportunity costs of staying idle

(2) Cyclical unemployment. Also known as Keynesian unemployment. Closely associated with economic growth. Like now, the period of recession, clearly businesses no longer need so many workers since the demand for their goods & services had fallen.

Solution: Government has to increase public spending & reduce taxes. Increase in G will jump-start the economy since it’s part of the component of AD. Hopefully through the multiplier effect, will lead to a secondary increase in AD. Cut in direct tax will induce more people into work since it increase the level of disposable income

(3) Structural unemployment. Unemployment that results due to mismatch of skills. The problem is these workers are just too specialised & they may find difficulty to move in between jobs. For instance, a welder is displaced by a robot or a nuclear engineer is no longer required in a lab.

Solutions: Government provides incentives to firms to train these employees to make them more marketable for other jobs & also incentives for those unemployed to join the training scheme

(4) Geographical unemployment. Unemployment caused by difficulty to move from an area with low demand to areas with high demand for labour. This is often caused by social factors like family ties, cost of living etc

Solutions: Government can consider giving incentives to firms e.g. tax breaks, investment tax credit etc to set up businesses in areas with high unemployment. Also, they can actually reduce barriers to free movement. Notably, EU has reduced the border controls thereby enabling workers from e.g. Hungary to come in easily & work in UK. However, there could be other barriers like language

(5) Real wage unemployment. Unemployment that is caused due to high wages in the economy. It could be caused by any of the combinations such as strong trade unions, wage rigidity & minimum wage. Strong trade unions can cripple the whole economy. UAW (United Auto Workers) is a good example of how a union nearly destroyed the Big 3 & subsequently put US in the mercy of Japanese & Chinese (to buy their bonds). They often ask for wages that are absurd even in period of difficulty like now. Secondly, there are some wages that could be difficult to be adjusted downwards, e.g. workers with long term contract. Lastly, high NMW (national minimum wage) can lead to unemployment as firms will demand for lesser workers if per hour pay is high

Solutions: The US government can follow the stance adopted by Margaret Thatcher in paralysing the strong labour union. However it is very politically unpopular

Consequences of Unemployment

Unemployment in US on the rise since 2007 is at accelerating rate in 2008

Unemployment in UK had reached all time high of 6%. Also going up at accelerating rate

Implications of unemployment

(1) Fall in real GDP. Labours, just like land & capital is considered as factors of production. Higher unemployment rate means lesser labours are being hired in the market. Therefore this necessarily translates to lesser goods & services produced in an economy. The fast rising unemployment in major developed economies such as France, Germany, US, UK & Japan largely explains why these countries are already officially in recession (unemployment & contraction in GDP are inter-related actually). Recession is defined as 2 successive quarters of negative growth
However, if job losses are due to firms becoming more capital-intensive (use more machineries), then real GDP may not fall

(2) Loss of income. Unemployed people may have lower standard of living. This is because, they no longer have sufficient means to maintain their living style as before. Even if they get Jobseeker’s Allowance it is of minimal amount & it actually erodes their purchasing power. Although one could argued that sometimes the unemployment benefit (which is not same to every individuals) provides more income than working & the increased free time may be considered more valuable than working, rest assured this falls into minority case

(3) Negative multiplier effect. The jobless state could eventually spread into the whole economy. Think of this. Woolworths is about to go into administration. It is going to shut all its 807 stores with the workforce of 27, 000 people in January if it can’t find a suitor. Say all these workers are laid off simultaneously. It will immediately cause a fall in consumption which triggers a contraction in real economy. Firms earn lower profit or even losses or even go bankrupt. In return, they are firing workers too. The cycle just repeats itself

(4) Loss of tax revenue. Unemployment will immediately cause a fall in direct tax & indirect tax. As lesser number of people is working, government receives lesser income tax. As firms felt the impact of negative multiplier effect, they make lesser profit or losses. So government collects lower corporation tax. Also since lesser people spend money onto buying goods & services, there would be fall in VAT

What government can do is increasing the tax onto those existing workers or cut government spending. Rest assured, both are viewed as politically unpopular stance.

(5) Increase in unemployment benefits. This resembles an opportunity costs of how government can spend their money. It is argued that those monies are better spent productively to stimulate the economy by creating employment through the building of schools, hospitals, motorway, infrastructures, telecommunications etc. Workers which receive ‘the dole’ may become complacent & might just rely on the benefit rather than making an effort to search for jobs

(6) Social costs. Being jobless, can pressurised an individual to commit offenses such as snatch theft & robbery. If prolong, other things may happen. In the period of Great Depression in 1929-1939 people are unemployed so long that the suicidal rate actually increased. Also being jobless for so long can degrade an individual self-esteem & fall in productivity. From other angle, children from unemployed households often had poorer education & hold fewer skills on the average, upon entering work

Media & Its 'Contribution' To The Paradox of Thrift

Fall in house prices ‘welcomed’ –11th May 2008
House prices dropped 1% in June –28th July 2008
House prices double digit fall –4th September 2008
UK house prices continue fall –2nd October 2008
UK house prices to fall by 30% --15th December 2008
Mortgage arrears to hit 500, 000 –18th December 2008
Lender axe house price forecast –19th December 2008
Mortgage lending shrinks again – 23rd December 2008
House prices will fall further –24th December 2008

I guess I don’t have to do much explanation here. All those news were taken from BBC & in fact these are just an insignificant portion of the broader coverage on how the UK housing market performs. We still have Telegraph, Financial Times, Guardian etc

Source of diagram: BBC

If you observed both from the news & the graph, price of houses in UK is continuously nose-diving. There are many factors contributing to these particularly on the demand side. The fact is that increasing number of people have chosen to shun away from the property market. Why? Because they are waiting for a period ‘comfortable’ or low enough as an entry point. In other word, people are deferring spending onto big items.

Here comes the relevant concept-paradox of thrift, propounded by the great British economist, John Maynard Keynes in the early 1930s during the period of Great Depression

According to him, recession or even depression can be self-reinforcing. If individuals think that in the current period of recession, increasing personal saving is the best thing one can do, then ultimately this will do more damage to the whole economy & to that individual itself. To further support, it makes huge economic sense to save & defer current spending since there is much space for house prices to fall. Why buy now when one can buy at a cheaper price later?

But if everyone thinks the same, demand for houses will fall. Dipping house prices will hit nation’s newspaper headline & people will continuously think that house prices are yet to rock bottom. As such spending is further postponed. This brings substantial damage to homeowners’ wealth since UK has large proportion of people storing their wealth in property market. Many have went into negative equity & that is amount of loan greater than value of house

This will further reduce economic confidence & aggravate contraction in economic activity. Therefore DEPRESSION is the word! UK economy is one the worst hit in Eurozone given huge contraction in economy is heavily owed to falling property prices.

Perhaps, the Britons may need to learn from the Great Depression in Japan & avoid the same thing happens again

Well, we can’t blame the media for ‘indirectly causing’ the recession. They are just doing their job anyway

Wednesday, December 24, 2008

How Does Negative Multiplier Effect Works Into Whole Economy?

Negative multiplier effect: An initial fall in AD which subsequently leads to a much larger fall in GDP

To see how damaging the effect towards the entire economy, let me illustrate with an example:

We begin with the ailing financial institutions. Due to the collapse or near collapse of many large firms such as Lehman Brothers, AIG, Citibank, Goldman Sachs, Freddie Mac & Fannie Mae, many had begun to restructure their operations. Among the most common measures taken are to retrench workers to minimise the operating costs, especially in the current climate of heavy losses

The first round of large scale unemployment had caused humongous drop in private consumption (C). Since C is a component of AD, therefore AD must necessarily fall. In reality, real GDP begins to slow down & inflationary pressure starting to ease. Since these people spend lesser on the High Street, businesses begin to see losses or fall in profitability. Since the demand for their goods or services fall, it makes no economic sense to maintain those workers who are now idling around in a quiet shop. Therefore this leads us to second round of retrenchment. Unemployment rate increases again. C further fall, economic growth rate is slowing down at a faster pace & price level shrinks again.

This creates fear even among those who still have a job. As such fear over job insecurities lead to their cut in spending. Unemployment is reported on the rise again next month & this is the third round of retrenchment. Does it stops here or just affect people or businesses in certain area?

Let’s look at how this spreads. Inability of bank to generate lending due to credit crunch also caused demand for housing to fall. As property market becomes gloomy, they will in return retrench their workers causing the same effect as mentioned above. As no one turns into buying house, this has a negative spill over effect to other related industries such as kitchen companies, furniture shops, lawyer firm, mortgage advisors etc. Therefore the effect is magnified through rising unemployment once again

Is that all? Wait. Difficulty in generating lending, had also caused large banks to turn down the appeal of GM, Chrysler & Ford to access funding to restructure their operation. It is well known that the Big 3 were not making much (even make quarterly losses) in the recent years due to the fast falling market share compared to Japanese car makers. If assistance is not given, their collapse will add about more than 1,000,000 workers to the unemployment statistic. Don’t forget, many industries are relying on car such as wind screen & gearbox manufacturers etc

Basic Understanding of Bond

Usually, when we talk about investing, people will be so excited (or sad) to tell you how much they have made from stock markets (or how much they have lost). If you brought up the topic of investing in bond, people will be shunned away from the conversation. Well, given the broad publicity & coverage about stocks/ equities in all major newspaper as well as investment magazine, I wouldn’t be surprise that bonds do not generate the same sex appeal as stock investing

I’m not that certain about bond market here in Malaysia, but in more developed financial market such as US, the financial institutions do provide their clients with the service of buying government securities. What they need to do is to open an account with a bond broker which normally requires a minimum of $5000 deposits

Investors often overlook bond investing as normally the return is not that high compared to stock market. But in the bearish period such as now, it’s just too risky to throw our hard earned money into the wave of volatility. Not even investing in unit trusts fund is save for now (I lost nearly 70% of my investment). So in US, increasing number of people have chosen to throw their money into buying government securities, even though the interest rates are near to 0%. They do so as they perceive the chances of government to go default is very low. Why is it so? This is because government can always payback bond investors by the way of higher taxation. As such government bonds are also popularly called risk-free assets

Who & why issue bonds?
Government issues bond for various purposes. From infrastructure development to welfare programs or even to the extent of bailout. Firms issue bonds as they may want to expand the business, purchase of capital goods etc. The thing is, large organisations often need more cash than an average banks can provide. Therefore they also seek funding from the investing public

How bonds & stocks differ?
In bonds we are the lender/ creditor to government or firms BUT in stocks, we are the shareholders & we own part of the corporation (most of us are insignificant shareholders). Also shareholders are entitled to voting rights & profits of the firm, and as such are given dividend payments depending on the profitability of the company

For bondholder, they have a higher priority in claiming the assets than an ordinary shareholder. In case if any bankruptcies, a bondholder will get paid before shareholders. Although they do not entitled to dividends, they to get periodical coupon/ interest payments plus the principle amount
Types of bonds
I’m not that certain about the variation of bonds that exist in US market but generally there are 3 types. First is Treasury bill with maturity period of 1 year or less. Another is Treasury note with maturity 10 years or less & finally Treasury bond with maturity period up 30 years. This is what the US government often issued & the Japanese & Chinese government often take up

For corporate bonds which are riskier, are assessed by Moody’s & S&P. They will give a credit rating to these bonds. I’m sure you have seen somewhere signs like AAA, Aaa, CCC etc. Blue chip firms normally have higher ratings while risky firms may get poorer ratings. This will help investors to assess their risk appetite

How it works?
Interest rates & bond prices are inverse in relation. Say, if interest rates increase, bond prices will fall & vice versa. Why? Let me illustrate with figures (this is an over-simplification)

Bond with 10% coupon rate & at par value of $1000. Bondholders will get $100 every year (10% x $1000) which are paid semi-annually $50 & $50. But if the price goes down to $800, then its interest rates will be 12.5%. This happens because bondholders MUST GET the same guaranteed $100 ($800 x 12.5%). Conversely if bond goes up to $1200 the interest rates will drop to 8.33%

The ultimate return at the end the period is called YTM (yield to maturity) which equals to all the interest payments bondholders receive PLUS any gain (if bought at discount-below $1000) or loss (if bought at premium-above $1000)

Market force of demand & supply also play vital role in determining the price of bonds. In US, since there is no reliable form of investment at the moment, therefore most people throw their money into bonds. As demand for bond increase, therefore it pushes its price to higher level. As such this reduce its interest rate. Remember the interest rate & bond price works in different direction

Bonds also called as fixed-income securities typically because investors income are known & fixed (periodic payment of interest rate)

Video Lesson by Richard Pettinger: Deflation

Are They The Same? Low inflation vs. Deflation

Not to the question. This always causes an interpretation problem to students & laymen on the street.

What we meant by lower inflation say 6% (September 08) vs. 5.5% (October 08), is prices of goods & services are increasing in October BUT at a SLOWER rate. Another thing, never ever develop the thinking that inflation has fallen by 0.5% (6%-5.5%). That is very wrong!

Deflation is a general fall in price level of the economy. Here it means general prices of all goods & services used to construct the CPI index are really FALLING. An illustration will help the understanding:

Say, CPI in 2008 = 179.9 & CPI in 2009 = 177.1. Therefore,

Rate of inflation = (177.1-179.9) / 179.9 x 100 = -1.6%

Here -1.6% means falling price level. Goods & services have fallen by 1.6% in general

Saturday, December 20, 2008

What Will Happen If Interest Rates Fall To 0%

Base rates in UK as in December 2008: 2% (lowest since 1951)

US base rates: 0%-0.25% (the lowest since 1954)

It is ‘interesting’ to see how US government & the Fed react to the economic doldrums in States since they are the main causal of all this mess around the world. The experience, skills & wisdom of policymakers are tested once again, after an economic slowdown short after the 9/11 event.

Recently, one of the boldest move taken by the Fed is slashing the key rates to as low as between 0% - 0.25%, a level lower than in 2002. Having said so, one should not be misled to think that now firms & consumers can go to banks on high streets & borrow money to expand business, acquire capital goods or buy property for FREE

What this means is that, commercial banks itself can borrow money from Fed for a very limited period of time without paying much interest as before. But since it is standing at such low level, from practical point of view whether it is 0.1% or even 0% doesn’t matter anyway

What do 0% interest rates mean?

(1) Carry trade activities. The most famous event is yen carry trade. It happens throughout the long lost decade in Japan, in 1990s where interest rates were held at 0% up to last year where interest rates are still very low at 0.5%. It is a situation where borrowers or investors taking advantage by borrowing cheaply in yen to save or invest in countries that yield much higher interest rates such as Euro, UK or even in US. If the exchange rate is stable they could easily profit 4% to 5% after deducting all those transaction fee. Perhaps this could happen to America, if the situations in States worsen while Eurozone begins to show sign of recovery & other emerging economies remain robust

(2) Traditional monetary policy has come to an end.
Monetary policy has always been an effective tool to combat inflation, to manipulate how people & firms spend, managing the exchange rate, prevent unemployment rate etc. In period of rising property prices such as early 2000s to mid 2000s in both UK & US, interest rates were raised to cool down the economy. In US it went up to 5.25% while in UK 5.75% before coming down. But in period of downturn, rates will be aggressively adjusted downwards to prevent deflation. Now it is standing at 2% in UK & I believe that it will go down further in coming months. In US, it makes not much difference by saying that now it’s at 0%. Therefore we say, traditional monetary policy tool can no longer boost the economy. It runs out of ammo

(3) Quantitative easing. The Fed will have to turn to unconventional tools like quantitative easing. This means an attempt to increase money supply in circulation, hoping that it will encourage greater lending & greater economic activity over time. In modern terms it is equivalent to printing more money. What the Fed will do is buying up all those government bonds or debts & mortgage backed securities issued by Freddie Mac & Fannie Mae. This is somewhat similar to Japan’s effort to combat deflation. Increase in money supply, will always ensure that the interest rates are kept low. Although some economists argued that this will lead to inflation or even hyperinflation, it is not much of our concern now. My argument is that velocity of circulation had fallen steadily. Second, the threat of deflation is seems to be the more realistic picture due to fast contracting economy

(4) Difficult to generate lending. One of the methods for commercial banks to generate lending is by using depositors’ saving. In fact one of the causal for the financial crisis is due to low savings ratio among Americans & Britons, which force banks to seek funding from money market. But given the interest rate is virtually 0%, in theory, banks saving will fall & as such again banks may find itself difficult to generate lending. However this may not be the case. The US & UK government had pumped lots of money into the financial system to increase liquidity. Besides, although base rate is at 0%, banks will likely keep savings & lending rate above 0% to attract depositors. As such the fall in lending rates is not so much of banks’ inability to do so, but rather their stubbornness to improve the balance sheet & recap some of the earlier losses

(5) Greenspan-Bernanke legacy. Economists blame Greenspan for all these financial mess. It was his policy to keep Fed rates as low as 1.25% in the early 2000s which lead to an era of cheap borrowing, which saw leap in house prices. The problem was aggravated by banks’ generosity to lend money even to lousy paymasters & people with irregular jobs. That time, they were too optimistic that the inability to serve repayments will be offset by the rising value of their houses. In short, all comes from a long period with low interest rates. Now, Bernanke seems to be of similar interest to Greenspan. In the medium term, will we witness another credit bubble burst? Will it help US to realise its dream to become an empire of huge debt due to another round of bailout & massacre spending? The next Fed reserve chairman will have to address these

(6) Deflation is almost inevitable. In general, hardly we hear any central banks decision to cut interest rates to even 1%, what’s more at near 0%. This is a sign that those policymakers are desperate since the economy is fast dying, threat of recession is stumbling in & period of deflation is almost imminent. One may think that since inflation-the period of sustained increase in price level is bad since it erodes our purchasing power, then what’s wrong with falling prices? Well, answer is no either! In period of deflation where prices continue to fall, people will postpone spending as they expect future prices will be cheaper. When everyone thinks the same, consumption & investment will be very low. This will pose a threat to major developed economies which are mostly consumption driven. Nearly 70% of US & UK’s GDP consists of private consumption

Why Lags Exist?

In economics, lags mean a delay. We often hear about recognition lags, implementation lags & effect lags but what exactly are they?

Recognition lags: Time taken by policymakers & economists to realise that something has actually happened in the economy

Implementation lags: Time taken for a policy to be instituted

Effect lags: Time taken before the effect of the policies can be really seen in economy

Why recognition lags could happen?

(1) New data is not released on daily basis. It takes time for the statisticians in ONS (Office for National Statistics) to collect, run the data, analyse & produce a report on all those macroeconomic variables. At the moment of writing, only the data of real GDP for the third quarter of 2008 (July-September) is available instead of December. On the other hand, number of people claiming jobseeker’s allowance while is reported every month still need about 2 weeks to report the data. The same goes for inflation measures. As such, we say that problems could have exist months ago & economists are just too slow in response

(2) Policymakers are ‘too careful’. Even if those policymakers have series of data for e.g. real GDP for 3 consecutive quarters which are declining, they may still reluctant to admit that the economy is ailing. They will believe that ‘it’s not more than a temporary fall’ since the economy is correcting itself. They will not believe that the economy is steering towards recession until the day where everyone is out of job. Similarly, the financial crisis is said to have happened in the 4th quarter of 2007. The early symptom in UK is where Northern Rock which went under administration & then nationalised. In US, economists argued that the government is relatively slow to throw in the bailout. It should be done much earlier rather than watching those financial institutions suffer larger loss such as AIG, Bear Sterns, Freddie Mac & Fannie Mae

Why implementation lags could happen?

(1) Bureaucracies. This is often associated with fiscal policy. Fiscal policy is the manipulation of government spending & level of taxation to influence the movement of AD. Say, in the period of slowdown government would pursue expansionary fiscal policy by increasing public spending & reduce level of tax. But in pursuing more spending, its legislation will have to go through various layers of administration. Also it may take quite a long time to secure suitable sites & planning permission. This may take from months to years

(2) Tax is tabled annually. On the other hand, tax changes whether direct tax e.g. income & corporation tax or indirect tax like VAT (value added tax) are usually announced in the annual budget. There is often a further time lag before they come into effect, although changes in taxes on addictive goods such as cigarette & alcohol and necessities may be more immediate

Why effect lags could happen?

(1) Some people on fixed rate mortgages. In the early 2000s, interest rate was standing at 3%. But over the years, due to rising inflation no thanks to property market boom, MPC had continuously adjusted the base rates upward. It was standing at 5.75% in September 2007. Owing this, many borrowers had begun switching from variable rate mortgages to fixed rate mortgages to avoid paying more. As such it is said that any cut in interest rates will not affect the consumption pattern of these people, not until at least the period of 18 months. Therefore, although the interest rates had been slashed to 2% in December, its impact may not feed through the whole economy until June 2010

(2) People & firms are cautious in spending. Even if interest rate is lower, it may still not affect those people taking variable rate mortgages. This is because consumers will look at broader aspects before deciding to take up any large commitments. They are concern about the health of UK economy, how severe are job losses, how much prices of house has fall, will prices fall further etc. For firms, interest rate cut will not cause them to immediately spend onto new capital goods, machineries or building new factories. Outlook of consumer confidence is very important as it will determine the demand for goods & services they produce

(3) Banks slow in passing rate cut. Financial institutions have been condemned for notoriously good at raising interest rates, when BOE or Fed raise it but slow in response to rate cut. This is because, increase in base rates could mean greater profitability for banks & vice versa. Even so, they may not pass on the full rate cut. For e.g. BOE slashed interest rates by 75 bps, but banks only reduce it by 25bps. This is very apparent in the current period, where banks are more keen in regaining some of the losses & also to build up their lending funds once again by maintain higher rates. This s also called recapitalisation

(4) Exports are inelastic in short run. Cut in interest rates will cause depreciation depending on how large is the cut. Wealthy foreigners, hedge funds & investment trusts will withdraw money from UK & park their money elsewhere which gives better return in interest rates. This is one of the major reasons as to why pound is fast depreciating against many other major currencies, & is set to be on par with Euro. As pound drops in value, buying from UK should be much cheaper & this will boost its export. However, demand for exports will often be inelastic in the short run e.g. contracts have been signed earlier & firms couldn’t adjust the amount of goods produce. But in long run, the positive effects onto current account will be seen assuming that PEDX + PEDM > 1

(5) Job creations gradually expand. It takes time for the whole economy to heal, which actually work through the multiplier effect. Firstly, it took ages for the government to kickstart the construction of schools, hospitals etc. Many new jobs are created in the first round. When more people are in employment, there will be more spending into the economy. Firms now face greater demand for their goods & services, thus hire more people. In the second round, private consumption is expected to be greater & this continues. Also, it has external benefits to firms as now they can invest more. All these lead to rebound of economy. But having said so, it is not done overnight

Should IJN Be Privatised?

Arguments FOR privatisation of IJN (Institut Jantung Negara)

(1) Budget constraint. Costs of running such privilege health institute are not cheap. A small & yet simple surgery equipments may costs several hundred thousands to millions. The costs of maintaining some of the best heart specialists & other costs such as R&D are increasing every year. At the same time, Malaysian fiscal deficit is widening & there could be limit as to how much government can continuously pump money into IJN

(2) To be more productive efficiency. Ideally, being a privatise institution there will be greater incentive to further reduce costs to achieve productive efficiency. This is a phenomenon where a firm will attempt to produce service at the minimum part of AC curve. Costs cutting will be the main objective as now it attempts to enlarge its supernormal profits

(3) More money for R&D.
Greater supernormal profits in the long run, will always ensure large pool of funds available to conduct R&D. Common field of focus will be on cardiothoracic, cardiology, anesthesiology etc. In the future, the medical team will be able to come out with various modern techniques to cure chronic heart diseases. It is also beneficial to heart patients itself

(4) Better service. Once privatised, IJN is said to be able to provide much better services, run more efficiently than before & meeting the need of heart patients. This is because it may no longer rely on funding from the Ministry of Health. As such, IJN will have to be really customer-oriented so that it can generate more funds for itself. Consumer welfare may be preserved

(5) Able to reduce brain drain. Once privatised, IJN will be able to retain those best doctors. Economically, when someone is being paid & reward handsomely, their productivity will increase. They are willing to work harder, provide better services etc. Sometimes it does make sense to pay someone higher than the market equilibrium wage rate. Arguably, with such high salary the doctors will always be at their best performance, since they may not be able to find similar pay somewhere else

Arguments AGAINST

(1) Basic rights. To provide universal healthcare for the people is utmost important. Furthermore, health is recognised as the basic human right

(2) Allocative inefficiency. Once go private, IJN will gradually charged exorbitantly on any heart surgeries, ward expenses, medical fee etc. Being a profit maximiser, necessarily they will operate where MC = MR. Here the price is the highest (P > MC). Government will have to intervene by then, to bring the price of IJN service down near to their marginal costs (MC) of providing it

(3) Productive inefficiency. IJN may not even attempt to produce at the minimum of AC (average costs) given that it face less competition & the demand for its service (heart related surgery) is highly inelastic. This is strengthened by branding of IJN as the leading heart institute in the region

(4) Reduction in patients’ welfare. Staff meetings will become sessions for discussing how medical procedures could generate revenue, the profitability of various units, how to make patients stay longer in hospital etc. Although patients are said to receive better attention in wards, their welfare is offset by the lust of private entity for profits

(5) IJN is already one of the best. Over the years more people, private sectors & foreign governments have acknowledged the high standards adopted by IJN without the benefit for privatisation. Other top hospitals like Singapore General Hospital & the Queen Mary Hospital in Hong Kong are government-run institutions. So I don’t think there is any need for privatisation for it to achieve excellence

Economics of Credit Card & Debit Card

What is substitute good? How do we know if two goods are substitute of one another?

Substitute good is good that can be used in place of another. There are many types of substitutes, with some strong & some weak in relation. Weak one could be tea & coffee (XED near 0), moderate (XED around 0.5) such as McDonalds & Burger King & strong ones like Pepsi & Coca-Cola (XED near 1)

Substitute goods have POSITIVE cross elasticity of demand (XED more than 0). It is given by the formula,

XED = % change in quantity demanded for good A/ % change in price of good B

XED is necessarily positive due to the mathematical relation. For e.g. if the price of a Coke increase (positive % in price), people will drink lesser Coke & switch over to drinking Pepsi (positive % in quantity demanded).

As such when a positive numerator is divided over a positive denominator, the outcome is always positive. The outcome such as 0.2, 0.35, 0.9 etc is the strength of substitubility

Is debit card a close substitute to credit card?


(1) Low fee vs. high interest rate charge. These 2 act as price. Since credit card charge is much higher, in theory people will demand lesser credit cards & more will switch over to debit card. To strengthen the argument, debit card fee will always be lower than credit card charge since, the former involves customers drawing money from their own account while the latter is borrowing from the bank. It does not make logical financial sense, if you’re being charge higher for taking out your own money

(2) High cash transaction. In Malaysia, the proportion of cash transaction to non-cash transaction is 4:1 (The EDGE, Dec 15) & this means that general public still prefer to pay out of their own wallet rather than relying on credit from banks. As such, the market for debit card is vast & there is huge potential to tap this segment. According to MasterCard Worldwide, in the event of economic slowdown, debit MasterCard posted a 22% year-on-year growth in worldwide transaction value to US$ 554 billion, with 6.87 trillion transactions

(3) Increasing applicants. In the recent months, banks have begun to promote debit cards more aggressively than credit card. First, they realised that the market for this plastic card is huge. Secondly, credit card market could have reach saturations after so many years of aggressive pick up. Here, debit card issuance is around 15, 000 every month & that is fast growing

(4) People realised that it is difficult to control spending appetite. There is a high tendency for credit card applicants to overspend beyond their means. Coupled with high interest rate charges, the amount of money we owe could skyrocket in matter of months. Although there is a ceiling imposed by banks, more often than not it is set at quite a high level & thus encouraging overspending. Once switched over, the fear of hanging with debt load will be eliminated as every swipe comes from one’s savings account


(1) 24 hours charging limit. Some debit cards may limit spending in a day. As such if someone who wish to purchase huge items, they may not be able to do so

(2) Credit card is more superior if you spend wisely. Not all the time credit card users are hit with high charges for not settling the bill each month. Sometimes the lender will give applicants a break in the form of float. Float here means a grace period that we have, to avoid interest on a purchase if there is no balance in our cards at moment of purchase.

(3) Attractive rewards for using credit cards
. Increasing number of credit card companies or banks offer various benefits, annual fee waivers, attractive cash & non cash prizes such as cars just to attract more applicants. At moment of writing, debit card is about to expand in Malaysia & its attractiveness is not towards as ‘developed’ as credit card. Furthermore, banks can rely on the demographic dividend that we have & that is increasing number of young executives. As such one could argue that the vast different in rewards to card holders, reduce the level of substitubility between the 2

Benefits to debit card applicants

(1) No fear of overspending. With every swipe, monies will be deducted from the users’ bank account. There is always a limit to how much one can spend, unlike in credit cards (limits are set too high)

(2) Reduce costs of obtaining cash
. There is no such hassle to walk or drive to the nearest ATM machines. That reduces cost like time wasted, petrol etc

(3) Everyone can apply for debit card. As long as one having a savings account, he or she is entitled to debit card. Also there is no age restrictions & income requirements. This truly benefits those working people whom may have income below requirement & thus not eligible to apply for credit card

Benefits to banks/ issuers

(1) Cross-selling other products. Applicants for debit cards will definitely need to have a savings account with the bank. As such the bank is said to have cross-sell other of its banking products. Also, this could be a source of funding for banks to generate lending

(2) Greater supernormal profits.
Although the bank may not earn much fee with every swipe, but owing to the vast potential of the market, it means higher transactions which automatically means greater revenue & therefore supernormal profits

(3) No risk of NPLs (non-performing loans). Debit card is a safe products for banks. It would not add to defaults like what we have for credit card. This is because monies are deducted from users account. Unlike the latter, monies are borrowed from banks & as such inability to meet timely repayment or default can adversely affect banks’ balance sheet

Saturday, December 13, 2008

Is Too Much Growth Desirable?

Definition: Economic growth is a sustain increase in real GDP

There are many reasons for us to cheer for economic growth:

(1) Lower unemployment.
In the period of high economic growth, generally there will be greater demand for goods & services. There will be an increase in retail sales, more people dine outside, more traveling etc. To produce these firms will necessarily employ more people. Workers are therefore derived-demand. Firms do not increase employment just for the sake of doing it

(2) Lesser social problems. Increase in employment will automatically contribute to lower crime rates such as robbery, snatch thefts etc & other problems such as alienation due to low self-esteem

(3) Rising income. In the period of high economic growth, earnings will be on the increasing trend. As people now have more money, they can afford better various services such as additional medical care, education, recreation & travel & goods of better quality. All these contribute to higher standard of living

(4) Increase in leisure. Higher level of output could probably be achieved by using fewer labour. People may benefit from shorter working hours & can have longer holidays. Also, entertainment industry tend to boom in period of rapid economic growth. There will be more cinemas, theme parks, pubs etc

(5) Increase in tax revenue. As people generate higher income, they are subject to higher direct tax from the government e.g. income tax. Firms will generate greater profits & therefore subjected to greater corporate tax. These two will lead to increase in government’s revenue which thereby can be used to finance public spending such as national defense, police, benefits to disabled & sick, build more schools & hospitals, upgrade infrastructures & telecommunication

(6) Further increase in AD & AS.
Increase private spending into the economy associated with rising employment will lead to a secondary increase in AD due to multiplier effect. Also, the money that people spent now becomes the profit for firms. Businesses can have greater allocation for reinvestment & this will have a long term supply side effects. AS will increase. Increase in both AD & AS to the right will further boost the existing economic growth

(7) Increase in wealth. Higher profits mean greater dividend payment for shareholders. Also firms’ share prices will skyrocket when the public has confidence with prospect of the company. Growth will also give a boost to property market. High consumer confidence will always fuel the demand for property market which actually translates to higher price of houses. All these have positive wealth effect

Economic growth has been the holy grail of studies in economics. Although increase in national output increases economic prosperity, but does that necessarily mean that people’s standard of living increase?

Disadvantages of economic growth

(1) Opportunity costs. From the PPF (production possibility frontier) argument, more capital goods will be produced at the expense of consumer goods. There will be lesser fashionable clothes, plasma TVs, DVDs etc. From economics point of view, when a country chooses to have more capital goods now, it means current standard of living will be lower. Somehow, standard of living will increase in the future. More capital goods by then can produce more consumer goods

(2) Depletion of scarce resources. Economic growth may mean we use up scarce resources more quickly. There will be lesser availability of oil, coal, metal & other natural resources in near future. By then, there will be lesser capital goods. The existing one will probably worn off & inefficient in production. One day, food supplies may diminish & the world population may suffer

(3) More lands allocated for factories. Lands are scarce too. As number of factories is increased to meet the rising demand of goods, it means lesser land available for parks & other recreational activities. This may offset the increase in standard of living due to greater consumption of goods & services

(4) Negative externalities. Rapid economic transaction leads to various negative externalities such as air, river, noise & fume pollution that may contribute to various ailments. Also it aggravates deforestation which will result in flooding, loss of biodiversity, loss of species & climate change. China which shows an impressive growth of at least 8% in the past 2 decades had been blamed for being one the world’s leading contributors to regional & global environmental problems including acid rain & ozone depletion. Also more cars on the road contribute to accident statistics

(5) Rising unemployment. Technical progress may soon cause firms to be capital-intensive rather than labour-intensive. Furthermore, this may lead to greater costs saving in the long run. It could be a matter of time, before machineries in manufacturing sector began to replace the role of a typical worker. This could severely contribute to structural unemployment, where unemployed workers find themselves immobile between jobs, due to mismatch of skills

(6) Rapid urbanisation. From development economics point of view, rapid industrialisation will attract massive inflow of workers from the rural area to urban. Somehow, the main concern is inability of firms to absorb such surplus of workers. As such urban unemployment has replaced rural unemployment. For those poor rural migrants, once they arrived they will face the immediate problem of getting an affordable housing. Therefore they will construct their own houses in the midst of city. This is called urban slums/ shanty towns. More problems follow suit, such as difficulty to get access to clean water, no electricity etc

(7) Social stresses
. Rapid business transactions require individuals & firms to make wise & yet fast decision. Wrong decisions made may lead to large scale of losses. Also some people may find difficulty to cope in a fast pace working environment e.g. lots of paper works with tight deadlines, dynamic changes in working method etc. To finish up their work, very often more time are spent in office rather than with loved ones. Japan & South Korea are said to adopt such working culture

(8) Inflationary pressure. In the period of economic growth, unemployment drops, earning power increase & robust consumer confidence will always ensure strong private consumption into the economy. As AD shifts rightward, price level will increase. Inflationary pressure therefore builds up

(9) Worsen BOP (Balance of payment) deficit. BOP records the financial transaction of one country with the rest of the world. Economic growth is often associated with increase spending onto imported goods & services. People from UK may demand for more LV bags, Swiss watches, international holiday etc. All these are example of outflow of money. Since all these are recorded as negative under the current account (one of the component of BOP), this actually worsen the BOP deficit

The Closest Model Of Monopolistic: Kar Heong Restaurant

I have a good experience conversing with the manager of Kar Heong Restaurant, Mr .Tong over some issues pertaining to food business. By the way the restaurant is very popular in Subang (front of Metropolitan college) & now they are opening the branch in Sunway Damansara, very near to my place though

Among the issues he brought to me were:

“There are so many restaurants in such a small area, all providing different range of food & some are famous brands. The business is so competitive & there are several restaurants which have gone bankrupt in recent months (pointing to the latest casualty, the corner one). Some attempt to salvage whatever they can, to new tenants”

This quickly reminds me of monopolistic competition:

(a) Market with many sellers, but not as many as in perfect market

(b) Each sells goods (food in this case) that are differentiated by branding (Kar Heong in this case)

(c) There is some price making ability. Each restaurant operators charge the price they want for different types of food they serve

(d) Normal profit in the long run. Earlier, this area was not so developed. There were barely few restaurants that occupy most of customers. That time they earn supernormal profits. But after a year or so, the believe that the area is prosperous have attracted more new comers, given the costs of setting up business is not that high. This means freedom of entry. As such short run supernormal profits are competed away & some may begin to make normal profits (AC = AR) in long run. Therefore they decide to leave industry

“Salvage whatever they can”- reminds me of sunk costs. Businesses with low entry barriers will normally have low exit barriers. This means, some of the fixed capital could be sell of for second hand usage, thus recovering some of the losses. This lower down the sunk costs

Says who Economics are merely textbook theories?

Why Global Economy Will Not Recover Next Year?

While the full-blown effect from global economy meltdown yet to be fully felt, there are already some economists that preach for global economy recovery by mid of 2009. However, I’m sort of pessimistic with their views. Here we will look at several global economic indicators particularly those from US, UK & the rests of Europe, Japan, China & India

These are my arguments:

(1) Recession had just begun. Recession is generally defined as fall in real GDP for 2 successive quarters. In US, the data shows that American economy have shrunk by 0.3% officially in the 3rd quarter. It is very unlikely that the data will turn around for the good in 4th quarter or even the 1st quarter of 2009 given the worsening economic outlook. Germany had also been announced as technically in recession. In fact the worst is yet to come. More companies are shedding employment. The future of US automakers together with millions of other jobs is still on the line. Hardly any recession will recover in months. We have seen the 1929 Great Depression, recession after the Barber Boom, recession after the Lawson boom, Asian financial crisis, Japan’s Great Depression. None of them take months to fully recover

(2) Dow Jones will suffer huge fall in weeks to come. This has to do with the future of GM, Ford & Chrysler. The officials from Big 3 had declared again & again that they only have matter of weeks before going under. The current administration highly rejected the proposal to bail out automakers. We are highly uncertain of the situation, not before 20th January 2009 when Obama swears in. However, market often reacts differently. Due to herd mentality, traders ‘want to believe’ that the Big 3 ‘will actually collapse’. Overreaction may send the Dow Jones plunging to another record low level in nearest future. Market around the world will likely react similarly: Hang Seng, Nikkei & other major indices. More wealth will be wiped off

(3) Record unemployment. In period of recession, it is very common to see firms firing workers. In such period, fall in private consumption will translate to lower profits for firms. They will no longer need to produce so many outputs, thus laying off idling workers. In October, unemployment in US is standing at 6.5%, the highest level in 14 years high. It could be more than 10% early next year if Detroits file for bankruptcy. The accounted for nearly 500, 000 workers. But there are many industries that rely on Big 3 particularly spare part suppliers. As such unemployment could be magnify to millions

(4) Consumption continues to fall. Consumer confidence falls to record low. Stresses built up in the system over unemployment, fall in average monthly disposable income, shrinking nest eggs & freefall in house prices. In UK itself, disposable income tumbled for more than 70% of households. All these translate to falling consumption. Over job insecurity & falling income, people dare not to take up any financial commitments at the moment. Meanwhile banks have never been so frugal. Number of mortgage approvals dropped significantly, leading to fall in demand for housing. As such prices of houses fall too leading to negative equity. People will feel inferior & poorer.

As both UK & US economy are consumption driven, this leads to a large fall in AD. Through negative multiplier effect this may lead to several round of fall in AD in months to come. This is my strongest argument as to why global economy is unlikely to recover by 2nd quarter of 2009

(5) Not much room for monetary policy & fiscal policy. In US interest rate is standing at 1%. For UK is 2% while Japan is 0.3%. It does not take a genius to see that there is not much space to further rely on monetary policy to put the economy back to pieces. Meanwhile, US government national debt as % of GDP is 73%, ballooning to unprecedented level. In UK, debt is still manageable at about 43% but still high though. In Japan, the figure is 194% of their GDP. Although they can still manipulate government spending, it is ought to be done cautiously. Japan is an excellent example of failures in policy. Despite proactive measures, its economy remain stagnant for a decade

(6) Increase in oil prices. OPEC will hold its meeting on 17th December in Algeria & I’m very optimistic for a larger cut in production of oil this round. It could be of 2 millions barrels a day. Some OPEC members are large lobbyists such as Nigeria & Iran. They are called the price hawks mainly because of their economy which is less diversified & heavily depending on revenue from oil. Demand for oil is inelastic (PED less than 1). As such, cut in production will lead to increase in price which subsequent boost its total revenue (P x Q). It’s annoying that some of the members claim that the oil price should stay at $70 at such a period. Whatever is the decision, oil price is estimated to increase by less than $5 & this could more or less dampen the effort of economic recovery

(7) Strong dollar & yen. Investors around the world have decided to withdraw their capital from emerging economies & Europe. In period of global recession, US economy will always be deemed as the most stable & vibrant. As such this creates the demand for dollar causing it to rise to a record level of $1.50 to £1. Meanwhile the end of yen carry trade has caused the resurgence of yen against many other currencies. Yen carry trade is the practice of borrowing in yen (cheap to borrow in yen) to invest in other countries that yield higher interest rates, taking advantage of the differential in rates offered. However, vibrant dollar & yen means relatively more expensive to import from these two. As such the demand for exports will fall, causing a fall in AD & thereby hurting the real economy

(8) Slowing capital inflow. Capital inflows to developing countries are estimated to fall by 50% due to credit squeeze next year, fuelling the fear that emerging economies are not spared from the crisis. This had been the prime pillar that supports the strong performance in NICs (Newly Industrialised Countries) in the past 5 years. Lesser capital inflow necessarily means fall in number of new firms set up. As such there will be lesser new jobs. There is also no clear indicator that credit crunch issue will resolve in near future. Banks have been reluctant to approve financing & pass on rate cuts. The logic is, if they pass on the rate cut in the form of cheaper borrowing, it means they will have to cut savings rate too in order to preserve their profit margin. If savings rate is low, they will fail to recapitalise & create additional loan